Corporate Finance Review for First Quiz

Aswath Damodaran

Aswath Damodaran

Basic Skills Needed

What are the potential conicts of interest that underlie a business and how do they manifest themselves in practice? Can you read a regression of stock returns against market returns?
- How would you use the intercept to measure stock price performance? - What does the slope of the regression measure? - What does the R squared of the regression tell you about risk?

.Can you use the beta to estimate an expected return on an investment? .What are the three factors that determine betas?
- What is the relationship between leverage and beta? - How do you estimate a new beta if a rm changes its leverage? - In general, how is the unlevered beta related to the assets that a rm has on its balance sheet? What effect do acquisitions and divestitures have on this unlevered beta?

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Corporate governance.. Use common sense

Assume that you are currently a stockholder in a rm that is the target of a leveraged buyout. From the perspective of conicts of interests between you and management, which of the following should concern you the most about this transaction?

The fact that the company will go private after the transaction The possibility that equity investors in the LBO can make huge returns The fact that the managers of your rm are also part of the acquisition team The use of a disproportionate amount of debt to fund the transaction None of the above

We usually see the stock prices of the target rm in an LBO jump on the announcement of an LBO. This can be viewed as evidence that
Markets are inefcient Markets are efcient Cannot tell without more information

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Reading a Regression: The Intercept

Intercept Rf (1- Beta) = Jensens alpha

This is what the stock actually did in a month in which the market did nothing

This is what the stock was expected to do in a month in which the market did nothing

Excess Return

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Key concepts to keep in mind about the intercept

It is the difference between the two (the intercept and the riskfree rate (1-beta)) that matters The intercept and the riskfree rate have to be stated in the same terms if one is monthly, the other has to be monthly as well.

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An Example

You have run a regression of returns of Devonex, a machine tool manufacturer, against the S&P 500 Index using monthly returns over the last 5 years and arrived at the following regression: ReturnDevonex = - 0.20% + 1.50 ReturnS&P 500 If the stock had a Jensens alpha of +0.10% (on a monthly basis) over this period, estimate the monthly riskfree rate during the last 5 years.

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The Solution

Data given: Jensens alpha = 0.1%, Intercept= -0.2%, Beta = 1.5; Find: Riskfree rate The Jensens alpha is the difference between the actual intercept and the expected intercept of Rf(1-), i.e. -0.20% - Rf(1-1.5) = .10%; Solving, we nd that Rf = 0.6%. What if I had asked you for an annualized riskfree rate?

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Annualizing Rates

Annual Riskfree Rate = (1.006)12 - 1 = 7.44% What if I had told you that the Jensens alpha was 2.4% on an annualized basis (instead of 0.1% on a monthly basis)?

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From betas to expected returns

Beta is a measure of the market risk in an investment. The expected return on an equity investment, which is also the cost of equity, can be written as Cost of Equity = Riskfree Rate + Beta (Risk Premium) a. The riskfree rate should generally be long term, default free and currency matched. b. The risk premium is generally estimated from historical data. It should be dened consistently with the riskfree rate. For emerging markets, an additional country risk premium may have to be added on. This country risk premium can be estimated

Simply by adding the default spread based upon the country rating to the US risk premium In a more sophisticated way, by estimating the relative equity market volatility and then adjusting the default spread for this relative volatility.

c. The risk premium can also be estimated from the market, in which case it is called an implied equity premium. When we use this premium, we essentially assume that the market is correctly priced.
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The riskfree rate and risk premiums: An example

You have been asked to review a beta regression done on Cemex, a large Mexican cement company, and the output is provided below: ReturnsCemex = 0.25% + 1.08 ReturnsBolsa R2 = 45% The Bolsa is the Mexican equity index and the regression was done using two years of weekly returns. Assume now that the beta from this regression is correct and that you are trying to estimate the cost of equity for Cemex in Mexican pesos. The ten-year Mexican Government bond rate in pesos is 8.35% but the Mexican government has a local currency rating of AA, with a default spread of 0.65% associated with the rating. The risk premium for the US and other mature markets is about 4% and Mexican equities are three times more volatile than Mexican bonds. Estimate the cost of equity in pesos.

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Estimating cost of equity

Riskfree rate in pesos = Mexican Peso 10 year rate Default spread for AA rated bond = 8.35% - 0.65% = 7.70% Risk premium for Mexico
Equity risk premium for US (mature market) Additional Risk premium for Mexico = 0.65% (3) Total Equity Risk Premium for Mexico = 4% = 1.95% = 5.95%

Cost of Equity
Riskfree rate = 7.70% Beta = 1.08 Risk premium = 5.95% Cost of equity = 7.7% + 1.08 (5.95%) = 14.13%

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Betas and Fundamentals

The beta of a rm reects three fundamental decisions a rm makes

a. The type of business it is in, and the products and services it provides. The more discretionary these products or services, the higher the beta. b. The cost structure of the business as measured by the operating leverage c. The nancial leverage that the rm takes on; higher nancial leverage leads to higher equity betas

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The Example: Financial Balance Sheet

You have been asked to estimate the levered beta for GenCorp, a corporation with food and tobacco subsidiaries. The tobacco subsidiary is estimated to be worth $ 15 billion and the food subsidiary is estimated to have a value of $ 10 billion. The rm has a debt to equity ratio of1.00. You are provided with the following information on comparable rms: Business Average Beta Average D/E Ratio Food 0.92 25% Tobacco 1.17 50% All rms are assumed to have a tax rate of 40%.

Tobacco Food Total

Assets $ 15 billion $ 10 billion $25 billion

Debt Equity Total

Liabilities $12.5 billion $ 12.5 billion $ 25 billion

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Calculating the Unlevered Beta

To nd the unlevered beta of the rm, we need the unlevered betas for tobacco and food. The betas given for the industry are levered betas (regression betas always are), and the average debt/equity ratios for the industry are used.
Unlevered Beta for Food Business = 0.92/(1+(1-.4)(.25)) = 0.8 Unlevered Beta for Tobacco Business = 1.17/(1+(1 - .4)(.5)) =0.9

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An Updated Balance Sheet

Assets $ 15 billion $ 10 billion $ 25 billion Liabilities Debt $12.5 billion Equity $12.5 billion Total Firm $ 25 billion

Tobacco Food Total Firm

0.9 0.8 0.9 (15/25) + 0.8 (10/25) = 0.864

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The Effects of Leverage

Unlevered Beta = 0.864 Levered Beta for the Firm = 0.864 (1 + (1-.4) (12.5/12.5)) = 1.376 Cost of Equity = 6% + 1.376 (5.5%) = 13.57%

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The Effects of Divestiture

Tobacco Cash Total Firm Assets $ 15 billion $ 10 billion $ 25 billion 0.9 0 0.9 (15/25) + 0 (10/25) = 0.54 Liabilities Debt $12.5 billion Equity $12.5 billion Total Firm $ 25 billion

Levered Beta for the Firm = 0.54 (1 + (1-.4) (12.5/12.5)) = 0.864

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Use the Cash to Pay of Debt

Assets Liabilities Tobacco $ 15 billion 0.9 Debt $2.5 billion Cash 0 0 Equity $12.5 billion Total Firm $ 15 billion 0.9 Total Firm $ 15 billion Levered beta for the firm = 0.9 (1 + (1-.4) (2.5/12.5)) = 1.008

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Use the Cash to Buy Back Stock

Assets Liabilities Tobacco $ 15 billion 0.9 Debt $ 12.5 billion Cash 0 0 Equity $ 2.5 billion Total Firm $ 15 billion 0.9 Total Firm $ 15 billion Levered beta for the firm = 0.9 (1 + (1-.4)(12.5/2.5)) = 3.60

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Use the cash to pay of dividend of $ 2.5 billion, pay down debt of $ 7.5 billion

Tobacco Cash Total Firm

Assets $ 15 billion 0 $ 15 billion

0.9 0 0.9

Liabilities Debt $ 5 billion Equity $ 10 billion Total Firm $ 15 billion

Levered beta for the firm = 0.9 (1 + (1-.4)(5/10)) = 1.17

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Use the Cash to buy an internet rm for $ 10 billion

Tobacco Internet Total Firm

0.9 1.8 0.9 (15/25) + 1.8 (10/25) = 1.264 Levered beta for the firm = 1.264 (1 + (1-.4)(12.5/12.5)) = 2.02

Assets $ 15 billion $ 10 billion $ 25 billion

Liabilities Debt $12.5 billion Equity $12.5 billion Total Firm $ 25 billion

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Use the cash + debt of $ 5 billion to buy and internet rm for $ 15 billion
Assets $ 15 billion $ 15 billion $ 30 billion Liabilities Debt $17.5 billion Equity $12.5 billion Total Firm $ 30 billion

Tobacco Internet Total Firm

0.9 1.8 0.9 (15/30) + 1.8 (15/30) = 1.35 Levered beta for the firm = 1.35 (1 + (1-.4)(17.5/12.5)) = 2.48

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Test yourself
Assets Sell Asset Buy asset with cash on hand Buy asset with new stock or equity issue Buy asset with new debt Pay dividend Buy back stock Retire debt Replace asset with cash Unlevered Beta Decrease D/E Ratio No effect Levered Beta Decrease

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A Test..

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